This would allow us to
predict and prescribe the content,
direction, and size of multilateral trade
flows.

MERCANTILISM
1500-1800

not a full-blown trade theory (see
above); rather,

an economic policy of governmental
accumulation of wealth, in the form of gold
bouillon for:

domestic control

investment

international expansion

reflects the era of nation-building
and the shifting of European political power
from feudal lords and the church to national
sovereigns; also reflects and supports
the principal source of wealth -- trading

The trade-policy implication of this economic
policy was the generation of a national trade
surplus, paid for by accumulation of gold
reserves.
Before fully developed financial systems, there
was little international credit. Therefore,
a current-account surplus was not matched by net
capital outflow (net loans or investment
overseas); rather, it was matched by a net
inflow of gold to pay for the excess of goods
exported from the country. Some of this gold
found its way to overseas investment by the
sovereign.

ABSOLUTE ADVANTAGE
1776: Adam Smith's The Wealth of
Nations

Political and economic liberalism found their
expression in Smith's argument that the wealth
of nations depends upon the goods and services
available to their citizens, rather than the
gold reserves held by the sovereign.

Maximizing this availability depends, first, on
putting all resources to use, and then, on the
ability --

to obtain goods and services from
where they are produced most cheaply (because
of “natural” or “acquired” advantages), and

to pay for them by production of the
goods and services produced most cheaply in
the country,

with costs measured in terms of direct
and "embedded" labor inputs.

This principle fit the development of capitalist
economies based on production via wage labor
(rather than trading commodities for
profit); reflects the manufacturing
dominance of Britain; reflects manufacturing
economies of scale based on:

- development of specialized equipment;
- labor training and specialization;
- long "runs" of one product.

These are sources of acquired advantage.

The consequent trade policy is relatively free
trade, so that a country should import goods
that would be produced more expensively
internally, where expense is measured according
to the labor theory of value.
These imports are to be paid for by the
production of goods that the country can produce
with less use of labor per unit.
Exports flow from the country that can produce a
product most cheaply.

COMPARATIVE
ADVANTAGE
• 1817: David Ricardo's On the
Principles of Political Economy and Taxation
• The possibility of system-wide gains from
trade persists, even when a given country has an
absolute advantage in the production of no
product.
• Specialization and trade should occur
according to the relative opportunity costs of
production in each country, measured in terms of
the alternative production given up to produce a
tradable good.

Example:

resources required per unit output:

Tea

Wheat

Sri Lanka

10

10

United States

5

4

The opportunity cost of tea in Sri Lanka is
1 unit wheat; the opportunity cost of
tea in the US is 1.25 units wheat. Sri
Lanka has comparative advantage in tea
production, despite its absolute disadvantage
in the production of each commodity.

To test for comparative advantage in the
production of commodity A in a 2X2
model: for which country is the
opportunity cost of A smaller -- which is to
say, for which country is the ratio of
resources required for a unit of A to the
resources required for a unit of B smaller?

Although the US has an absolute advantage in
the production of both tea and wheat, the US
has a comparative advantage only in the
production of wheat. This is because its
advantage in wheat is comparatively greater
than its advantage in tea [Daniels and
Radebaugh, 8th ed., p. 202].

• In Root's phrasing, "gainful trade will occur
between countries when their pretrade relative
price structures are different" [F.R. Root, 1990,
International Trade and Investment, p.45].
How are the gains from tradedivided
between two trading partners?
If xi refers to the domestic
cost of producing x (a or b) within
country i, and Ci/Cj
refers
to
the
exchange
rate
between currencies i and j (how
many units of Currency i equals one unit
of Currency j), then:

trade is gainful when ai/bi
(the ratio of the costs of producing a
and b in country i) is not
equal to aj/bj (the
ratio of the costs of producing a and
b in country j)

if ai/bi <
aj/bj, then i
will export a and import b, so
long as exchange rates allow:

ai/aj < Ci/Cj
< bi/bj
(which is to say that the exchange rate is not
so extreme as to wipe out the differences in
opportunity costs for each item across the two
countries).

For example:

US beef costs $10 in the
US
US cameras cost $20 in the US
Japanese beef costs ¥5000 in Japan
Japanese cameras cost ¥1000 in Japan

· Without a common numeraire (such as
labor-value), we don't know the absolute
advantages. However, the relative values
within the two countries, 1/2 and 5/1, tells us
that the US comparative advantage is beef and the
Japanese comparative advantage is cameras.
Why? Because if costs are accurately
measured, then the opportunity costs of beef (in
terms of cameras foregone, since there are only
two possible products) are lower in the US than in
Japan: 1/2 a camera foregone in the
US; 5 cameras foregone in Japan.
· Despite this clear comparative advantage,
trade will only occur if
10/5000 < $/¥ < 20/1000, which is the
same as
0.002 < $/¥ < 0.02, which is the same
as
1/500 < $/¥ < 1/50.

Q: What would make the dollar fall so
much against the yen that a dollar would buy
fewer than 50 yen, and this bilateral trade
would end? (That is, in a world where
neither currency was used for other
international purposes, and where there was no
monetary policy).
A: Such a low Japanese demand for US
beef and such a high American demand for
Japanese cameras that the exchange rate fell
this low.

This relative demand for products from trading
partners, expressed via its effect on exchange
rates, determines the division of gains from
trade.

At $1 = ¥200, the US will import 2 cameras
for each unit of beef it exports; this
is 1.5 more cameras than it could make
domestically in lieu of one unit of
beef; the US gain from trade is 1.5
cameras per unit of beef.

At $1 = ¥183.33, the US will import 1.83
cameras for each unit of beef it
exports; the gain from trade becomes
1.33 cameras per unit of beef.

At $1 = ¥120, the US will get $10 = ¥1200
for each unit of beef it exports to
Japan; this would allow the US to import
1.2 cameras (at ¥1000 each); this is 0.7
more camera than the US could make
domestically at the opportunity cost of 1 unit
beef, so the US gains from trade is 0.7
camera/beef.

The equation below notes that the gains to country
1 from exporting commodity a is the
amount of commodity b that can be imported
from country 2 (per unit of commodity a
that is exported) minus the cost of producing
commodity a for export (expressed as the
amount of commodity b that is foregone).

The first ratio (A1/B2)
is the ratio of (i) the unit price that
Country 1's exports fetch on the world market
(in terms of Country 1's currency) to (ii) the
unit price that Country 2's exports fetch on
the world market (in its currency).

The second ratio (C2/C1)is
the
exchange
rate:
the
"price"
of the exporting country's currency, which
(without capital or money markets) is also a
measure of the relative demand for that
country's exports.

The third ratio (a1/b1)
is the opportunity cost of producing the
exported product in the exporting country.

(A1/B2)(C2/C1)
is what Country 1 can get in return for
exporting a unit of a

a1/b1
is what Country 1 gives up as it produces a
unit of a

So can you see why (A1/B2)(C2/C1)
- a1/b1
is the "gains from trade"? Wait, ask
yourself -- can
you see why?

Note, then, that G1 (the
exporting country's gains from trade):

increases with the relative unit price
of Country 1's vs. Country 2's export items
(this reflects the global supply/demand
balance for these items),

increases with strength of the Country
1's currency, and

decreases with the opportunity costs
(in Country 1) of producing the exported
item.

Let's run through the Japan/US example,
above, using this formula. a1 = the cost
of producing the US export item, beef,
in the US = $10/beef. For now,
let's assume that costs equal prices: a1
=A1
.b2 = the cost
of producing the Japanese export item,
cameras, in Japan = ¥1000/camera.
For now, let's assume that costs equal
prices: b2 =B2
.C2/C1 =
the exchange rate, varied; let's
take the example where it's ¥200/$1. b1 = the cost
of producing the alternative product,
cameras, in the US = $20/camera.

As you think about this, and view the graphs in
the textbook (Figs. 6.2 and 6.3), you'll
recognize that we're making some assumptions:

We assume that national production is on the
production possibility frontier (PPF), with no
un-used factors (e.g., no unemployment).
If some available and relevant factors are not
being used (e.g., labor unemployment in the
export sector), then we can't clearly say that
producing more of the export item would mean
producing less of other items.

We assume that factors are homogeneous
within a country (e.g., L is perfectly
substitutable across individuals and across
sectors), so that workers, capital, and
resources not used in one sector can work in
another.

To make the numerical example simpler, I've
assumed that prices equal costs (including a
standard rate of return to capital and
entrepreneurship). That's not always the
case: sometimes prices are much higher
than costs (e.g., in a monopoly), and
sometimes international prices are lower than
domestic costs (that's called
"dumping"). We can deal with this by
recognizing that a1
might differ fromA1
and b2 might
differ fromB2.

We've ignored transportation costs -- but we
could implicitly include them in A1 and B2 in the
first term of our gains-from-trade equation --
or we could add
them in as a variable in the first term
-- this would allow us to show what
happens with transportation costs fall (e.g.,
with containerization) or rise (e.g., with
higher fuel prices).

We assume that factor prices reflect the
value of marginal product attributable to the
factors. In reality, this is affected by
the competitive structure of the industry
(higher but declining in a monopolistic or
oligopolistic industry), the nature of the
factor markets (supply is restricted in the
case of unionized L or the guild professions),
and finally, wages/salaries are not solely
determined by economic forces.

These are all problems with using traditional
trade theory to understand and to prescribe
trade flows in the current economy.

FACTOR
PROPORTIONS
1935: Bertil Ohlin's Interregional and
International Trade, based on earlier work
by Eli Heckscher

What explains the differences in opportunity
costs for producing the same product in
different countries? Possibilities include
skill or technology (including a preference for
producing in different ways), availability of
materials or resources, or the pricing of
inputs.

Assuming:
1) ubiquitous technology (the same everewhere),
2) general preferences to use the best available
methods,
3) perfect competition in domestic factor
markets (which should push factor prices to
reflect their opportunity costs),
4) input requirements that differ across
different products, but
5) only one particular mix of inputs for each
different product, and
5) immobility of factors,
comparative advantage should depend on relative
factor availability.

• "A country has a comparative advantage in the
production of goods that use relatively large
amounts of its abundant factors of production
and a comparative disadvantage in the production
of goods that use relatively large amounts of
its scarce factors of production." Goods trade
can be considered the indirect trade of factor
services [Root, p.69].
--> What is meant by abundant
and scarce? Measured by relative
prices received by an additional unit of two
factors, in one country versus that relationship
in another country -- in other words, geography.

Complications:
1) heterogeneous factors -- of differing quality
for specific production processes
2) substitution within a production function (a
given product can be made with different
proportions of inputs, depending on the relative
prices of inputs in different places or at
different times)
3) raw-material extraction is based on absolute
advantage

The principles of
comparative advantage and factor
proportions form the basis of the
traditional, neoclassical
theory of international trade.
Note that this is a normative
theory, in that it asks the
question "If we had a goal of
maximizing world production (the
goods and services available to
citizens of each country), how
would we proceed?" If we
assume that

resources
(a.k.a. factors of production)
are immobile, but that

goods are
mobile and

technology is
stable and ubiquitous,

then we maximize
world production and the goods and
services available to each country
by using resources for the
production of goods that face
the lowest opportunity cost
within each country, and
trading the locally unneeded
products for other goods, produced
with the lowest opportunity cost
for resources in other
countries.

LEONTIEF
PARADOX
1953: Wasily Leontief published "Domestic
production and foreign trade: the American
capital position re-examined" in Proceedings
of the American Philosophical Society
(v.97).
1956: Wasily Leontief published "Factor
proportions and the structure of American trade:
further theoretical and empirical analyses" in Review
of Economics and Statistics (v.38):

Using data available from the 1947 input-output
(I-O) model of the US economy, Leontief
calculated the capital and labor requirements
for the production of $1 million of US exports
and $1 million of US production in
import-competing industries. He
found that

US export sectors (industries)
required a higher proportion of labor than

US production in those sectors in
which the US had substantial imports.

Why is this a paradox?

The US is capital-abundant and labor-scarce,
relative to the rest of the world.
(That's why US wages were the highest in the
world in 1947.)

The principle (or theory) of factor
proportions says that a country should have a
comparative advantage in the production of
goods and services that require large
proportions of the country's abundant factor
and smaller proportions of the country's
scarce factor(s). If a country has an
open (free) trade policy, market forces will
result in exports of the goods and services in
which the country has comparative
advantage. (This is the same as saying
"Free trade results in specialization and
trade according to comparative advantage.")

US export sectors required a higher
proportion of labor (the value of labor used
in production as a proportion of total
production costs) than did US sectors in which
the US had substantial imports. You can
rephrase this to say "US exports are more
labor-intensive than US imports."

The paradox: why is a capital-rich
country exporting relatively labor-intensive
products?

Analogous results were found in Japan, which
was then L-rich and K-poor, yet Japanese
exports were more K-intensive than Japanese
production in sectors that faced import
competition.

Possible explanations of the
Leontief paradox(see a similar
expositionby E.K. Choi)
Focus on the boldfaced
explanations

1. The US was not really capital-abundant
and labor-scarce. Perhaps all the troops
returning from World War II flooded the labor
market. [It turns out that this is not a
good explanation.]

2. The principle of factor proportions is
wrong. [This would be so upsetting to
trade theory that economists searched for other
explanations. See explanation 3.]

3. US sectors that faced import
competition became more capital-intensive than
the competing imports. This makes
sense -- if you're a manufacturer in the US, and
you have to compete with imports, you'd start using
more sophisticated equipment and fewer workers,
because your workers are probably more expensive
than your foreign competitors' workers.) Notice
that Leontief did not have data on how these
imports were produced overseas: he had
data on how these sectors operated in the
US. Perhaps these sectors were actually
labor-intensive in the countries that were
exporting to the US. [This is indeed a
partial explanation of the paradox.
HOWEVER, this suggests that the same product can
be made in different ways. If THAT'S the
case, how can you have a principle of factor
proportions -- which relies on an assumption
that some products are labor-intensive
(everywhere), some products are
capital-intensive (everywhere), and some are
land-or resource-intensive (everywhere).

4. There are different kinds of labor,
and each should be considered a separate
factor. The most common (though
simplistic) way to distinguish labor is to
separate "unskilled,"
"moderately skilled," and "highly skilled"
labor. In 1947 the US may have been
the most well-endowed country in the world in
highly skilled and moderately skilled
labor. Its exports were indeed
skilled-labor intensive relative to its imports
-- PRESERVING THE PRINCIPLE OF FACTOR
PROPORTIONS. Furthermore, skilled labor is
more expensive than unskilled labor (because it
is scarcer than unskilled labor, everywhere in
the world), so skilled-labor requirements
"inflate" the proportion of labor costs within
total costs. [This is a partial explanation of
the paradox -- and see the product
life cycle model, below.]

5. The US imported natural-resource
commodities whose extraction is
capital-intensive, but in which other nations
have an absolute advantage.
In other words, some trade occurs based on where
the products are found, not on their labor- or
capital-intensity of production.
[Empirically, this a partial explanation;
the paradox was more apparent in US bilateral
trade with resources-rich countries (e.g.,
Canada), and was less strong when
natural-resource sectors were excluded.]

6. Technology itself is a nation-specific
factor of production, rather than being a
universal attribute of production.
Furthermore, technology is a factor that is
produced within a given nation (much like a
commodity), but is not perfectly mobile or
tradable. This kind of thinking has led to
"neo-technology theories of trade" (see below). [This
is potentially an explanation of the
paradox; US exports -- including cotton
-- were and are more technology intensive than
its imports.]

PRODUCT
LIFE CYCLE
• Raymond Vernon, 1966, "International trade and
investment in the product life cycle"

• Concepts of product cycles had been developed
in industrial economics and in marketing since
the 1920's. Vernon, however, became
concerned with the technological bases for PLCs
in the late 1950s. with his work on the New York
Regional Plan. He later extended these
concerns to the international realm.
• Concerned with only certain products:

· manufactured goods (or services that can
be produced remotely from consumption, like call
centers)
· income-elastic demand
· L-saving in use

• His original formulation also assumed a ranking
of nations by income and wage levels, with
steadily rising income and wage levels of the
ranked nations.
• Assumes that product innovation is market-led
[define product versus process innovation;
technology-push versus market-pull models of
innovation].
• Assumes that process technology undergoes stages
distinguished by labor-intensity, standardization,
unit cost, and ability for technology to be
embodied in capital equipment and standard
operating procedures.

With these assumptions, Vernon built a
story of these particular kinds of products
facing
1) introduction in the highest-income,
highest-wage country where the products found
their first demand; production is
small-scale, changing, expensive, and uses
highly skilled L; demand is not very
price-elastic, because of differentiation, and
the nature of pioneering adopters
2) growth of demand and production in
the original country, with declining costs and
prices; some export demand from countries
with lower incomes and wages — the high-wage,
L-scarce country is exporting L-intensive
products
3) maturity of demand in the original
country, with standardized and increasingly
K-intensive production; establishment of
foreign operations in newer markets to serve
them and to overcome real or threatened trade
barriers
4) decline of product demand in the
original country, with increasing competition
from other suppliers and other products;
the cost pressure and the ability to embody the
technology in K equipment and SOP pushes
production "offshore" to low-wage countries,
using financial K and K equipment from the
originating country — the high-wage, L-scarce
country is importing K-intensive products,
because the K and technology are mobile within
the MNC, while the less-expensive L is not
mobile.

This helps resolve the Leontief paradox
by explaining, for a limited class of goods,
US exports of these goods while they are
L-intensive and import of these same goods
when they are K-intensive.

However, this model differs from the
Heckscher-Ohlin theorem:

technology changes over time, from L
toward K;

the mobility of technology changes
over time

standardized technology and financial
K are mobile factors within the MNC

Today, of course, international differences in
incomes and wages do not form a neat ranking, and
improvements in communication make it easier to
engage in new-product production anywhere within a
MNC's global production network.

1) Technology is an explicit factor of
production, but one that is itself produced
with inputs of capital and labor (and thus
endogenous to the model of growth).

2) However, the production of new technology
reflects decreasing returns to the application
of capital and labor (doubling the resources
allocated to new technology does not
immediately double the rate of technological
advance).

3) The production of new technology creates
externalities: all the benefits of new
technology can't be appropriated by the entity
(firm) that invests the resources to create
the technology.

4) There are increasing returns to scale in
the use of technology (a little
technology goes a long way -- can be used to
improve quality or reduce cost of infinite
number of units). More generally, there
are increasing returns (economies of scale)
for the facility, organization (company), and
country that specializes in a specific
product.

5) While technology is mobile (across
companies and countries), there is imperfect
mobility of the ability to use technology,
based on localized investments in
infrastructure, institutions, and labor.

6) Most
importantly, says Krugman, is the assumption
of increasing returns to scale
(unit costs of production fall with
increased scale of output). For
advanced manufactures and for many services,
this results in benefits from
specialization (the more a company
or country produces of a very specific item,
the lower the opportunity costs of
production). These benefits
include the ability to use and reuse
specialized technology, equipment, and even
reputation, at little additional cost.
This helps explain a country importing and
exporting in the same industry -- the imports
and exports can actually be different specific
forms of the same type of product
(automobiles, aircraft, financial
services...).

Results:

1) To the extent that individual
companies cannot appropriate all the returns to
their investment in new technology (because of
externalities in the development and deployment
of technology),

companies may under-invest in technology
(R&D) -- and

are very likely to under-invest in
"technology infrastructure" (e.g., education and
communications).

2) A country may gain comparative advantage
in a product because it was quick to gain
economies of scale in that product. As a
result, it can produce the product more
efficiently, relative to other products, than can
its trading partners -- not because of factor
endowments, but because of the skilled labor,
specialized infrastructure, networks of suppliers,
and localized technology that have developed to
support that industry.

3) With the additional assumption (which
is empirically based) that purchasers benefit from
a choice among similar products, we can see how
more than one country might gain comparative
advantage in similar products, based on (a)
similar factor endowments and (b) economies of
scale in the production of particular variants of
the products. This helps explain the
cross-trade in similar products, usually with
national variations -- think of the typical
variations among German, Japanese, Swedish, and
US-based automobiles.

Policy implications:
Thus, there may be a role in government support
of technology, via measures such as

R&D tax credits

trade policy to support key,
technology-improving sectors

"technology infrastructure"

1980s: strategic trade policy (industrial
policy) based on differential technological
linkages among sectors (some sectors lead to
development of skills, infrastructure, and
institutions that foster further innovation across
a range of related industries)
c.f. the importance that Porter places on “related
and supporting industries” to national
competitiveness.

SUMMARY:
NO ALL-PURPOSE THEORY
This may all seem bewildering, but so is the
prospect of trying to predict and/or prescribe the
myriad international trade flows. Trade in
different products is likely to be best
interpreted by different models, as I implied when
I noted the characteristics of "product-cycle"
goods. Here's a stab at such a typology:

TRADABLE
PRODUCT

APPROPRIATE
TRADE MODEL

BASIS FOR
EXPORT CAPABILITY

extracted
resources

absolute
advantage

(1)
natural advantage: is the
resource available, and can it be
extracted and transported at reasonable
cost?(2) K availability for
extraction

region-specific
goods and services (products
such as Champagne or Roquefort,
services such as tourism requiring
luxury hotels on sunny, warm white-sand
beaches)

What trade or
development policies are implied by a desire to
promote these different types of export
capabilities?

TRADE TRAPS
Specialization and trade according to
comparative advantage may maximize world
production, but under some circumstances it may
not lead to increased wealth and living
standards in poorer countries. Two of
these "trade traps":

IMMISERATING TRADE
(concept
developed
by
Jagdish
Baghwati): If a country's imports depend
on its export of basic, raw commodities, the
country may face an inability to increase
export earnings for three reasons, each
related to the first term in our "gains from
trade" model, above:

Raising prices will reduce demand by a
greater proportion (because most raw
commodities can be accessed from other
countries, and because most raw commodities
have substitutes)

Lowering prices will not increase demand by
an equal proportion (because world demand for
many commodities does not increase
substantially because of a price
decline: think about world demand for
copper)

As the world economy increases, the world
demand for many raw commodities increases at a
slower rate (demand is income inelastic).

OVER-ABUNDANCE OF
POTENTIAL LABOR: If the
supply of labor is limited, then an increase in
labor demand (e.g., because of export growth) will
yield an increase in wages (and if the general
price level doesn't rise as fast because
productivity is increasing, real wages and living
standards will rise). However, some
countries have a seemingly inexhaustible supply of
additional labor, because of a slow but steady
shift of people from subsistence or agricultural
activity to an industrial labor force. Thus,
export increases may increase national income but
not wage levels -- leaving little incentive for
businesses to increase labor productivity.

WHAT IS LABOR "SKILL"?
This is a complicated and contentious
question. Let me propose this: the
level of skill required for a job relates to the
amount of time a person with typical mental and
physical ability would take to be very proficient
at the job. Imagine a physically capable
20-year-old with no formal education. How
long would it take for that person to be able to
be a good fast-food worker? Industrial
assembler? College professor?
Electrical engineer?